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Fear the Boom

There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.

–Ludwig von Mises

The Austrian Business Cycle Theory (ABCT) elaborates on booms and busts that are happening in the economy. As you might have guessed if you don’t know already, this series of booms and busts is known as the business cycle. ABCT was originally developed by Ludwig von Mises in his 1912 book Theory of Money and Credit. It built on the “monetary theory” of the business cycle which was developed by English classical economist David Ricardo and his followers. From this, the Austrians developed their own monetary malinvestment theory of the business cycle. Not only were Austrians able to explain the phenomena explicated by the Ricardian theory, but also the apparent entrepreneurial “bundle of errors” and the greater intensity of capital goods’ cycles.

Unfortunately, we won’t get into the in–depth analysis of the theory from the Ricardians here, as there would be far too much to go into without straying far afield of our focus. Additionally, there are a number of other schools with their own business cycle theories as well. For further detail, information on some suggested material has been included below.

The gist of the ABCT is that monetary inflation (expansion of the money supply) is the source of the boom, and the bust is the inevitable, necessary, painful, but healthy rewinding of malinvestments, and realignment of misallocated resources that characterized the boom. The question some would have, then, is “What about monetary inflation causes malinvestment and misallocation, and why do Austrians consider the economic cycle to be an inevitable result of it?” For the sake of simplicity, and the fact that it is still somewhat fresh in our minds, I thinkit best to answer that by applying it to the 2008 iteration of the cycle, what we know as the 2008 Financial Crisis. Now, as always with historical economic analysis, there will be plenty of complicating factors the relevance of which we can’t hope to agree on, so my purpose here is to shed light on Austrian Business Cycle Theory, not to try to demonstrate that 2008 confirms the theory. Here we go.

It’s easiest to begin with the previous iteration of the cycle, which concluded in 2001. Equipped beforehand with the ABCT, you could have seen the tech bubble coming, but would not have been able to predict into which sector all the new money would be going. However, once tech stocks and startups started to inflate, you would have seen it for what it was: a bubble that had to burst, a boom that had to bust. The Fed’s response to that bust was the same as (almost) always: more money, in a vain attempt to prop up the artificially high stock prices and low interest rates. It kept up these loose monetary policies for some time, creating the conditions for the next boom.

Where would all this money go? Who could guess, unless you were paying close attention to Congress’s renewed focus on housing, President Bush’s call for an “ownership society,” and what Government Sponsored Enterprises Freddie and Fanny were up to in buying up any and all mortgages from the banks. Mass moral hazard erupted, as banks could sell risky loans to these creatures of Congress and enjoy the upside without the risk. And this, in the eyes of the Fed and Congress, was a virtuous cycle — easy access to credit means more people buying homes, which meant rising home prices, which meant that even people who couldn’t afford the loans would be just fine: they could sell the house at a profit and do it all over again. The Fed swore up and down that it would never let this end, that it would intervene with every tool in its bag of tricks (all one of them) should it show any signs of letting up. So all these mortgages get securitized, because why not leverage the heck out of these can’t-lose underlyings? (And seriously, why not? Why should it have been prohibited, if the promises coming from Congress and Bernanke had any weight?) And so it was money, money everywhere — a boon to banks, investors, consumers, politicians, home builders, everyone, and this time it was to go on forever.

Not so fast. Let us apply ABCT (again, we’re not proving it, per se, rather describing it with a recent historical example). This new money going to banks for these questionable loans didn’t represent an increase in “real wealth” (actual goods and services). If I get new money, I have more purchasing power. And without monetary inflation, that’s the end of the story, because every dollar I have is a dollar somebody else can’t use to compete with me for scarce resources. But now everybody has more money, more purchasing power, and most of it is going into the same thing: ultimately into housing, which means lumber, bricks and ingredients for bricks, construction workers and so on. So the prices of these goods and services increase — and those prices signal the movement of more resources from other sectors (not out of thin air!) to partake in those new profits, driving prices back down through competition, until it looks — for awhile — like price inflation in that sector isn’t happening.

Except, of course, price inflation remains rampant in the final consumer good: housing. And this is seen as a beautiful thing — investors and homeowners are becoming wealthy, right? Seemingly, but all the labor, raw materials, and capital brought to bear on this result have been reallocated — not created ex nihilo like the money that bought them — away from projects which had been satisfying consumer demand that wasn’t artificially created by easy access to loans that were only available for participation in this sector. So I could buy a house without any (apparent) curtailment or deferment of other consumption. Taken together, then, the production of other goods became more expensive because the factors of production continued a steady march toward homebuilding, while demand remained relatively unchanged. Ventures across all sectors that had been profitable, and appeared as though they would stay profitable, suddenly weren’t — production costs rose as consumer demand remained unchanged, because scarce resources required for that production found a more profitable home in another artificially-inflated sector.

Marginally profitable businesses suffered losses, started laying people off and selling their land and capital. Unemployment began to rise, putting downward pressure on wages at the same time consumer prices were rapidly rising (price inflation peaking at 5.6% annualized, according to the Fed’s questionable indexing, just before the plunge in 2008). Again at the (subprime) margins, people suddenly couldn’t afford their mortgages. No problem at first — just sell for a profit, like everybody had promised. But this trend didn’t let up — a bubble was bursting — and soon there were so many foreclosures, so many unoccupied houses on the market, that housing prices began to plunge and the whole house of cards collapsed.

So this is essentially what ABCT predicts as the inevitable result of monetary expansion. It doesn’t predict into which sector (if any in particular) the money will go, but if it’s funneled anywhere in particular that will be the sector leading the bust. Prices will begin to rise far back in the structure of production, among “original factors,” i.e., land and labor, before spreading to higher-order goods such as capital and finally consumer goods, owing to competition for these scarce resources, these relatively nonspecific factors necessary for production across many sectors, with nonscarce new money.

Specifically it predicts that resources will be allocated to projects with longer production structures, and to the lengthening of those structures, as those projects suddenly appear more profitable than before, or than they otherwise would, because of lower interest rates. And it’s exactly those projects that will be most difficult, most expensive, most wasteful to unwind when the inevitable bust happens. What do you do with all the bricks, lumber, concrete, plumbing and so on in 20,000 half-built houses when you realize you’re not going to be able to sell the house for more than it cost you to build it? The cost of those materials has been rising for a while, but that was OK because so has the price of your final product. Until now, whereupon you are forced to choose between abandoning the project for a total loss, and finishing a project that should never have been started to recoup as much of your sunk costs as possible.

Austrian Business Cycle Theory, if I didn’t make it clear, holds that this result is inevitable, and I think it’s easy to show an amazing consistency in correlation (which is all you can get from empirical observation) even if you don’t accept the causal explanation which can only come from theory. It holds, further, that any attempt to forestall this inevitability with a redoubling of monetary expansion will only worsen, deepen and lengthen the inevitable result; that these misallocations and malinvestments must be allowed to be undone, sooner rather than later, so that these scarce resources can get back to where real market conditionswould send them. At best, the further expansion of the money supply can only create a new bubble in another sector as the malinvestments in the current bust are eliminated. Recovery would be quicker and stronger without such manipulation.

But why bring this all up? What is the relevancy of all this? Isn’t this really just preaching to the choir by informing libertarians of something most of them know? Is it simple academic discussion? Well, I find that this theory that has been contributed by the Austrian School to be one of the most important out there, and the housing crisis is a perfect example as to why. While I am an anarchist who chooses to work outside “the system,” I write this in an effort for those who may choose to work within the same system I am against. I seek to educate those individuals who would elect people to power, hoping to prevent the election of those who push for policies that start the cycle all over. With education on this topic, libertarians can persuade others and show that the powers that be are trying to solve the economic ailments with the same poison that created it in the first place. More government manufactured bubbles, more corporatism, more taxes, more spending. And when these bubbles burst, that’s not the end of it. They are going to recommend doing it all over again — which gives us good incentive to prevent it all from happening continuously.

However, as Mises stated, there is no means of preventing a collapse. Should we be in the midst of another bubble, it will pop. Perhaps as libertarians we can help those unfamiliar with this realm of economics to do what they can to abandon such catastrophic schemes. Theoretically, in a free market, activity does not affect a vast population like the state does now. (And if it does, it is limited to those that accepted the risks.) If you don’t know what the government is doing with your money, you’ll blame the wrong policies and ideas when it hits the fan.

Yet this does not only go to those that do not know the ABCT, but to those that may be more familiar with Austrian theories. Why would this be important to those individuals? Well you know from the ABCT that certain markets are saturated with low interest rate debt. So you know it’s not sustainable, but that doesn’t mean you can’t get in and out quick and make a buck. I would be wary of attempting to do so, because no theory will tell you when the bust will happen, only that it must as a result of the lack of sustainability with what has occurred. I’d also suggest to libertarians, and anyone else reading, to invest carefully. For instance, be cautious of the stock market since the stock market is not tied to economic health at all. The stock market can be manipulated by the Fed’s money creation, which creates bubbles that are not the result of actual sustainable production and only increase speculation using newly printed money. When investing, I would urge to not place all your eggs in one basket. Even less state-manipulated avenues of investment like Bitcoin, while holding much promise, are not a foolproof success nor immune to the bubbles created by the Fed’s creation of fiat money.

Killer write up! Theory only goes so far in conversation – people want examples. Obviously, as you said, there are other factors to consider but it’s a great example of “here’s how an Austrian would explain this.” And in the long term, people can watch the world around them to see if they can pick out the next boom.